Following the Global Financial Crisis many investors have fled share markets for the safety of Government Bonds and now safety has never been more expensive, or dangerous.

This can be seen in fund flow figures that show (blue bars) that investors have withdrawn money from share markets since 2008 and heavily invested into bond funds since that time.

In Australia the 10 Year Government Bond yields are around half of what they were before the GFC, as is the case in the US. The chart below shows the income yield for 10 year Australian Government Bonds. The key point here is that there is an inverse relationship between bond yields and bond prices, in that as yields fall, bond prices rise. Conversely as bond yields rise, bond prices fall.

In other words, as interest rates on Government Bonds rise, investors in those bonds stand to lose capital.

How much do interest rates have to rise before investors start losing money? The table below is sourced from the Wall Street Journal and shows that investors in US 10 year Government Bonds (yield at the end of 2012 was 1.84%) would receive a negative return this year if the yield rose to 2.23%.

And just how much could investors lose long term interest rates rise on Government Bonds? The chart below calculates the impact on bond prices of rising rates in various scenarios. The dark blue bar shows the value of a bond at current interest rates. The mid blue shows the value of the bond should rates rise by 2% and the lightest blue shows the value of the bond should rates rise by 4%.

The message is clear - investing in bonds right now has never been more dangerous and now is the time for investors to review these investments.

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

The European Stability Mechanism, which has funds of EUR 500bn, will be available for operation in the second half of 2012. This fund was the subject of a legal challenge to the German High court on constitutional grounds and this challenge was dismissed yesterday. The purpose of this fund is for recapitalising European Banks as well as funds to purchase Government Bonds in countries such as Italy and Spain in order to keep borrowing rates affordable for those countries.

The European Central Bank (ECB) has announced a program that will allow the ECB to purchase an unlimited amount of Government Bonds in the market for countries that seek assistance and accept strict conditions about aspects of their budgets. The purpose of this is to guarantee access to funding for European Governments at affordable rates. We have long argued that Spain and Italy are solvent countries, providing their borrowing costs do not become excessive. This announcement is critical in keeping interest rates low and has seen borrowing costs for Italy and Spain come down significantly as can be seen below:

Spanish 3 Year Govt Bond Rate

Spanish 10 Year Govt Bond Rate

Italian 5 year Govt Bond Rate

Italian 10 year Govt Bond Rate

Borrowing rate as at November 2011

6.25%

7.6%

(as of July 2012)

7.5%

7.2%

Borrowing rate now

4.4%

5.6%

3.7%

4.95%

We continue to believe that there is very little risk of a financial meltdown resulting from the Euro Debt Crisis or Financial Armageddon.

The Head of the European Central Bank recently went on record as saying “We will do whatever it takes to keep the Euro together, and believe me this will be enough”. He has backed up this rhetoric with the announcement to purchase an unlimited amount of European Government bonds for countries that request assistance.

Does this mean that this is the end of the crisis? Unfortunately not, however, we see these developments as very important building blocks that should stabilise the Eurozone and allow the Governments to carry out the necessary reforms to put their economies on a sustainable path. These reforms include tax, welfare, spending and labour market reforms.

In addition to these the other steps that the leadership of the European Union will need to take is to formulate plans for a Banking Union, and a closer Political union, which would result in individual countries surrendering some degree of control over their budgets in exchange for access to funding at cheaper rates and other economic benefits.

Currently the European Union is a currency union, arguably put together for political reasons, now they must bring together other aspects of their economies. This is not something that can be done quickly given the political pressures. The ECB however appear to have provided the necessary time for the politicians to get on with the job as the ECB alone can not resolve this crisis. This is where we see the main risk – with politicians and potential for the balance of power to shift over time.

The other main source of risk would seem to be with the very high levels of unemployment in countries such as Spain where overall unemployment is around 25% and youth unemployment is around 50%. This has potential to create social unrest which is difficult to predict.

Overall, we believe that the most recent steps are very positive moves forward that can provide the building blocks for the Euro Debt Crisis to be brought under control and financial markets have welcomed these moves in the form of lower borrowing costs for Italy and Spain.

There is an excellent video we produced earlier this year called “Fire Wall for the European Debt Crisis” that discusses the firewalls that have been created to ensure European Governments continue to have access to funding at affordable rates. This can be found by clicking the YouTube icon on our website at http://www.gemcapital.com.au and is well worth viewing. It runs for 6 minutes.

We trust you find this update useful and helps you put into context some of the information you are hearing in the media.

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.